Sunday, January 25, 2009

Like many other verities in the investment world, peak oil investment verities have turned out to be anything but. Investment newsletter writer and author Jim Grant likes to say that knowledge in the sciences is cumulative, but knowledge in finance is cyclical.

Even a stalwart of some peak oil portfolios, gold, managed to decline in the face of an obvious crackup in the world financial system. Everything seemed to be going down at once. The cause, in part, was that those who borrowed huge sums to gamble in the markets (mostly hedge funds and investment banks) had to sell at any price to pay back their loans before their investment portfolios completely vaporized. Selling begat more selling begat more selling. And with the selling, confidence in the financial system ebbed. The fundamental cause, however, was a swiftly declining economy, finally toppling under the burden of massive debt that individuals, companies and governments are increasingly unable to pay back.

This is not to say that some individuals who take peak oil seriously have not done well with their investments. But their strategies had to have been different from simply holding energy-related investments for the long run. The expectation for many peak oil investors had been that energy prices would rise more or less continuously due to increasing demand and constrained supply. That has not worked out as planned. Lately, economic contraction has led to declining demand which has had more influence on energy prices than any perceived constraint on production. But, of course, this doesn't mean that energy-laden investment portfolios might not prosper from this point on; no one can know for sure.

While the basic thesis of peak oil (and peak natural gas, coal and uranium for that matter) remains intact, its timing and exact effects continue to be elusive. Peak oil can still rightly qualify as a so-called "black swan event." The term, introduced to the public by former hedge fund manager and author Nassim Nicholas Taleb in his book "The Black Swan," denotes an unexpected and rare event of high impact which few people anticipate. It is precisely because few people anticipate it that is has high impact, and peak oil, though it is a better known concept today, remains poorly understood or unknown to the great majority of people on the planet.

The myriad factors that are leading us toward peak oil are not visible to any one observer. We can calculate, we can hypothesize, and we can prognosticate; but we cannot know for certain the date of its arrival or its ultimate effects on society and the markets. There will always be a gap between what we think we know and what we actually know.

The action in the investment markets ought to be a lesson for all those trying to envision what will happen in any complex system, especially one as complex as human society. Our powers of prediction are weak. We need to keep an open mind and observe carefully.

This doesn't mean we shouldn't try to plan or prepare or even invest. Humans are planning animals. But what they are really good at is improvisation. That's why careful attention to what is right before us rather than what we imagine for the future is of critical importance. The kick in the pants that all those who followed the peak oil investment paradigm received last year (including me to a minor degree) is a reminder that we ought not to allow our fantasies of the future to dominate our every action in the here and now.

Sunday, January 18, 2009

The Institute for Energy Research (IER) emailed me last week to warn me about the Obama administration's "green jobs" plan. The press release said that the plan would increase energy prices and actually cause total employment to decline. Furthermore, the release stated, renewable energy production has "stagnated" for the past 15 years, contradicting claims of vigorous growth.

The organization's assertions rely on a series of omissions. The first one the IER admits. It leaves out wind generation to claim that renewable energy growth has stagnated. Second, whether a massive government-led green energy program would lead to employment declines depends entirely on the assertion that money will be siphoned away from the nonrenewable energy sector of the economy. That now seems unlikely given the huge slack in the world economy and given that the plan is expected to be largely financed through deficit spending. But perhaps the most egregious omission is the failure to understand what market prices don't include in their signals to the economy and society.

For the IER, which dedicates itself to "free-market energy and environmental policy" and "private property rights," the struggling fossil fuel industry has succeeded entirely through ingenuity and pluck. The "scholars" (as they are called) at the IER seem to know nothing of the free work nature has conducted over the past few hundred million years in creating those fuels. Thus, the fossil fuel industry produces exactly nothing, but rather extracts the bounty of nature's work and delivers it to society. This is not an inconsiderable labor. But it amounts to privatizing the profits derived from the work of nature, while socializing the costs of using fossil fuels through such effects as global warming and toxic spills. (Here I should say that I do not think that this is a problem peculiar to the fossil fuel industry, but rather endemic in modern capitalism. However, the excuse that "everyone is doing it" should not shield the industry from reprobation.)

The price of fossil fuels (and especially recent prices) reflect virtually none of this reality; so perhaps the reason the people at the IER call themselves scholars is that their obsession with price renders them devoid of any practical understanding of the facts and frees them to focus on entirely theoretical matters just like the scholastic philosophers of old.

However, to focus entirely on the price of various fuels without contemplating their long-term sustainability, their environmental side effects, and their effects on the political and economic structure of world society is the equivalent of killing all but your favorite child so you can direct all your attention to him or her.

Still, even if we focus just on price, one would barely know by reading the IER's report on the green jobs proposal that oil had recently swung from under $50 a barrel at the beginning of 2007 to almost $150 last July to under $40 today. Similar price swings have taken place in the natural gas and coal markets. Such volatility is usually a sign of a system in distress. And, such instability makes it difficult for governments, businesses and consumers to create long-term plans.

Moreover, the ultra-low fossil fuel prices of today are a product not of exploration success, but rather economic implosion which is killing energy demand at a colossal pace. These prices are not a sign of plenty, but the result in part of the huge stress of high energy prices on the world economy in the last few years--stress that ultimately helped to tip a fragile economy into the first debt deflation since The Great Depression.

And so, the prices we are seeing for fossil fuels are creating an illusion of plenty that masks the central issue of our time: How do we move from our nonrenewable energy economy to a renewable one and do it quickly enough to avoid a catastrophic and rapid decline in the total energy available to human society?

Sunday, January 11, 2009

At the beginning of this decade investment advisor Marc Faber told incredulous investors that rising economic prosperity in Asia signalled the beginning of a new bull market in commodities, but would also have deflationary consequences for consumer prices. How could these inflationary and deflationary effects coincide? The answer has important implications for what is currently unfolding in the financial and commodity markets, and, in particular, the energy markets.

Before explaining why Faber believed such seemingly contradictory ideas, let's dispense with the technical monetary definitions of inflation and deflation. In their narrowest sense, inflation means an expanding money supply, and deflation means a contracting money supply. But whether the money supply is expanding or contracting, these definitions say nothing about where exactly that money goes. It is this question that concerned Faber, and it is in this context that he uses the words "inflation" and "deflation."

Most broadly, Faber wants to know whether money is chasing consumer goods and raw materials and thus pushing up what we normally call inflation as measured by the Consumer Price Index or whether it is chasing assets such as homes, equities, bonds, and even art. Policymakers and the general public normally favor the latter kind of inflation over the former. People feel richer as the value of their homes and stock portfolios rise and the cost of consumer goods remains stable or declines. More specifically, Faber wants to know which sectors of the economy are inflating, that is, receiving abnormal flows of money, and which are deflating, that is, experiencing a decline in money flows; to put it more simply, where are relative prices rising and where are they falling?

We should also mention the case in which the public and especially the investor class are clamoring for short-term government debt, bank deposits and money market accounts in an effort to shield their savings from losses. This occurs when we are either experiencing a transient panic or a generalized deflation in which money becomes more valuable as its supply contracts. That, of course, is what many believe is occurring now. There are many fans of asset inflation and even a few fans of raw material inflation--mining companies and farmers come to mind--but there are almost no fans of the generalized deflation we see today where the price of practically everything falls.

The fact that there is almost no political or economic constituency for generalized deflation is reflected in government and monetary policy around the world. Both types of policy have become highly expansive, and both are meant to get lending and economic activity growing again. Whether such policies will succeed at their aims or whether they are wise in their current form is a topic for another time. But it will be useful in the coming months to notice to which sectors of the economy money flows as the deflationary forces of the credit collapse and the inflationary forces of government fiscal and monetary policy collide.

To help us understand how Faber thinks, let's return to his observation at the beginning of this decade about the future course of the world economy, an observation that turned out to be roughly correct. At the time Faber reasoned that as manufacturing vastly expanded in Asia and global trade ferried the cheap goods produced there throughout the world, consumer prices would remain stable or decline. Simultaneously, a bull market in raw materials would emerge as the supply of materials to feed those factories would lag behind demand after two decades of underinvestment in mining, energy, and agriculture. Thus, there would come to be a disconnect between the prices of consumer goods and the prices of the raw materials used to make them. In Faber's terminology, one sector would be deflating and the other inflating.

The simple lesson from this is that money chases scarcity. That's why some sectors of the economy can inflate while others deflate at the same time. The economy never uniformly inflates or deflates. Even the current economic contraction will be no exception. First, what is scarce and in demand by definition becomes more valuable as people bid against one another to have what little there is of a scarce but necessary resource. Second, people tend to hoard what is difficult to get, especially if it is essential to their livelihoods or their peace of mind, and this further increases its scarcity in the marketplace. Third, speculators noticing the trend plow money into the sector of the economy where prices are rising through such investments as stocks, bonds, commodities, real estate and derivative securities linked to these. This further pushes up the price. As Faber would say, the chosen sector is "inflating."

Now, what can be scarce or perceived as such is virtually anything: food, metals, equities (believe it or not), and even financial peace of mind. To obtain financial peace of mind investors most recently sold stocks, commodities and corporate bonds and bought government bonds. Faber would say that the government bond market is "inflating" though clearly we are moving through a period marked by generalized deflation.

What this means for the coming year is that all of the money currently being willed into existence by the central banks of the world in an effort to stimulate the world economy will be going somewhere.* Since scarcity is the key to determining where those who have access to that money might put it, it is worth considering what might be perceived as scarce. (Disclaimer: The following shouldn't be construed as investment advice. Use it as such at your own risk. My task lies elsewhere.)

Certainly, paper promises in the form of stocks and corporate and mortgaged-backed bonds don't seem scarce. The thrill of paper gains that made them seem so has vanished. And, the crooked dealings of so many corporate executives has made owning individual stocks look far more risky than it seemed in the past. With monumental issuance of government debt throughout the world on the horizon, it is hard to see how government bonds will continue to be regarded as scarce much longer even though they may offer peace of mind to their owners for now. And, the various paper derivatives of all these investments could probably supply the world with wallpaper for a thousand years if turned into actual certificates. Hardly scarce!

What may turn out to be truly scarce is energy. There is no Wall Street paper mill that can turn it out as it does various securities. It can only be obtained through skilled, energy-intensive and highly complex processes. Right now the precipitous drop in world demand for energy has pummelled energy prices. What is not so obvious is that low prices and contracting credit are leading to low investment in the oil and gas fields, in the coal fields and in alternative energy technologies and deployment.

Even while many factories may now stand idle, the oil pumps, the natural gas pipelines, and the coal trains are still working relentlessly around the clock to bring us the energy resources we need and are therefore depleting the existing reserves in the ground. Without enormous and continuous investment, the energy industry cannot hope to keep up with this scale of depletion. Already for the past three years, record high prices for oil failed to conjure any additional daily production capacity into existence. Oil production was just about flat for the entire period.

With the ultralow prices we are experiencing now, the necessary capital will simply not flow to the energy industry to replace the reserves we are depleting or invest in alternatives to replace finite fossil fuels which will all reach a peak some day (perhaps soon) and then decline. (Many say that world oil production peaked in July 2008 and may never rise to that level again because of a combination of geologic constraints and the drop in investment in new productive capacity.)

So, my candidate for a surprise comeback this year or next is energy, even if the economy as a whole deflates more or just limps along at this level. If it happens, policymakers and the public need to see it for what it is: a certain sign that we are close to the end of the fossil fuel era. Even with the very high energy prices of this decade, we have not been able to build up the large inventory of new fossil fuel discoveries that might have been expected. It is getting harder and harder to find, extract and refine the nonrenewable energy sources that the world economy relies on for 86 percent of its energy. When the ongoing decline in energy supply capacity unexpectedly crosses with energy demand, that fact will be made plain for all to see if they want to see it.

What is likely to happen, unfortunately, is that once demand rises to meet available capacity or capacity shrinks to meet demand, catapulting energy prices will choke off any economic recovery which will in turn cause energy prices to plummet all over again. The high volatility in the energy markets, cycling from deflation to inflation and back to deflation again will make it exceedingly difficult for the energy industry to invest aggressively in finding new supplies. That is a problem that cannot be solved by central bank money printing or government spending, but which requires serious changes in policy and society, something that now seems sadly delayed though it is arguably more important in the long run than the economic emergency which we currently face.

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*For those who say that it is possible that more money will disappear from the world economy through debt defaults than will be created by central banks, this will still not prevent some sectors of the economy from inflating though they may be fewer and inflate less as a group.

Sunday, January 04, 2009

It is the mission of nearly every mainstream economist to overcome the pessimism of those who study the natural world and who don't see how the human endeavor can continue on its current course of endless exponential economic growth. "Now, now," these economists will say to the natural scientists, "you are being alarmist just like many before you. Let the marketplace work its wonders and let economic prosperity come to all parts of the world and this will enable us with our newfound wealth to address the many environmental problems we need to face."

Such arguments seem like mere nonsense to any scientist who believes that endless economic growth is the cause of those problems. But the difference between these two camps may be less than it appears. Enlightened economists do acknowledge the need to treat the environment which sustains us with more care. The main issue appears to be timetables.

Most economists believe that we are not in any imminent danger of societal collapse. We have plenty of resources and the big problem of global warming can be solved by taxing or otherwise restricting the use of carbon-based fuels. New technologies will give us what we need, in time and affordably. It has always been thus. (Except when it hasn't. But one would have to know the history of civilizations that did succumb to resource degradation and scarcity, and most economists are very much concerned with the utterly now.)

To the scientist who worries about sustainability and perhaps more urgently about the availability of enough energy, particularly oil, to run our society, this leisurely attitude seems quite dangerous. Partly, this is because the cheap fossil fuel energy we now enjoy will be needed to build the next energy economy. If we as a global society wait until the last minute to begin building that new energy economy, we may not have enough fossil fuels to do it. Those fuels may decline faster than we can replace the energy we currently get from them. This is often referred to as the rate-of-conversion problem.

Let us see how these different timetables might effect world society.

For the economist failure to grow would condemn billions to poverty, disease and ignorance. (Never mind that billions are condemned to that under the current system; but this is only because, as the economist will tell us, we haven't gone far enough with the spread of global capitalism.) If enough of the poor become middle class, their societies will undergo what is called the demographic transition. Birth rates will fall and so will death rates, and the population will level out or at least grow much more slowly. (Never mind that the true impact on the biosphere comes from per capita consumption and pollution times population, not population alone. Greatly increasing per capita consumption while slowing or ending population growth will not necessarily solve any environmental problems.)

But the path offered by my hypothetical economist is one without recourse. Once we commit to it, there is no going back. If the economist turns out to be wrong about the availability of resources or about the severity and pace of climate change, then global society could very likely face a fatal blow from which it cannot recover. There may be no second chance.

Let's look at an alternate path. If instead global society works very hard in the short term to curtail resource use and economize on energy use in an effort to reduce the throughput of physical resources radically, we may be able to build a highly efficient global economy that gives us many of the same services we have now. (Remember, it is not goods per se that we want, but the services they provide. We may want a car, but we want it because it is a convenient form of transportation. We seek the service of transportation.)

If we as a global society choose this path, and then it turns out that the pessimists in the scientific community are wrong about the severity of climate change and the availability of resources--that is, climate change turns out to be a minor problem and resource availability is much greater than anticipated by the pessimists--if this is the case, then we could choose to resume economic growth and use more resources to support it. In short, we would have a second chance to achieve the growth which the enlightened economist deems as necessary for the salvation of the poor. But we would do it within the context of a highly efficient, low-polluting system that tries to achieve all desired goals with minimal resource usage.

It is the asymmetry of risk in these trajectories that ought to give growth-oriented economists pause. Perhaps the economists will say that the risks simply aren't there. But then the record of most economists in predicting anything, even the direction of markets and market economies about which they presume to have specialist knowledge, has been nothing sort of dismal. Furthermore, the economists can give us no warranty for our society if it collapses under the weight of resource depletion and climate change. Wouldn't the more prudent path be to ensure that we don't have to face that possibility? Is the imperative for growth so great that we should risk the annihilation of our society in order to achieve it?